FX Themes for 2010

For most of 2009 the USD traded weaker pressured by low yields and improving risk appetite. USD in ending the year near a three and half month high supported by a shift in focus to improving US economic outlook and Fed rate hike speculation. We expect the USD to rally in early 2010 as the trade shifts focus to interest rate differentials and the correlation to risk appetite continues to breakdown. The key focus will be the Feds withdrawal of stimulus and timing of Fed rate hikes. The US labor market outlook is key to Fed policy. The Fed has indicated that rate hikes are unlikely until job is growth returns.

1) The timing of Fed withdrawal of stimulus and rate hikes/unwind of USD carry trade

Investors have become used to borrowing in USD and using the funds to invest in commodities, stocks and emerging markets. This is the USD carry trade and reflects the fact that US interest rates remain near zero and it is cheap to borrow in the USD. The USD should experience a short-term rally supported by the withdrawal of stimulus by the Fed, Fed rate hike speculation and unwind of USD carry trades. At the December FOMC policy meeting the Fed outlined details of possible exit strategies from quantitative ease and said it would let some stimulus measures expire. The Fed also reaffirmed commitment to maintain low yields for an extended period and gave no clue as to when the Fed may begin to hike rates. Many analysts have concluded that the recent improvement in US economic data will encourage the Fed to begin hiking rates by mid-2010. Other analysts however believe that the Fed is unlikely to hike rates for all of 2010. Which way market sentiment is leaning in regard to Fed policy outlook will be a key market driver for FX trade in 2010. Uncertainty about the timing of the Fed's tightening cycle will fuel FX volatility.

2) USD correlation to risk will continue to breakdown in 2010

Risk appetite will be less of a market driver and FX focus will shift to yield differential in 2010. The inverse correlation between equities and USD will be less strong in 2010. For most of the past two years improving economic news has been negative for the USD because the data fueled equity market gains and improvement in risk appetite. The improvement in risk appetite diminished USD attraction as a safe haven. After the release of better than expected US November employment and strong retail sales USD firmed with focus shifting to yield differential. Anticipation of the Fed's exit strategy and rising bond yields will boost the USD in early 2010. FX focus is shifting to more traditional fundamentals and abandoning the correlation to risk appetite.

3) JPY to re-emerge as the preferred funding currency

In early December the BOJ held an emergency meeting and announced that it was easing monetary policy and would provide three-month loans at 0.1%. The BOJ is expected to lag behind other major central banks and is unlikely to raise interest rates in 2010. Japan faces a continued threat of deflation with headline CPI reported to have declined by 2.5%y/y in October. If deflationary pressures continue in Japan the BOJ may be forced to ease monetary policy in 2010. US two-year bond yields are trading above two year bond yields in Japan by over 30bps. With the BOJ headed in the opposite direction of the Fed and ECB the JPY could re-emerge as the preferred global funding currency in 2010.

4) Global imbalances

Concern about the deterioration of the US fiscal outlook should have limited impact on the USD in 2010 as the US current account deficit has been narrowing and focus turns to fiscal deterioration in Europe and Japan. The US current account deficit has narrowed to its lowest level since the early 1990's. Japan announced a record ¥92.3trln fiscal budget for 2010/11 and bond issuance will exceed tax revenue for the first time since World War II. Sovereign debt ratings have been cut in Greece and Spain and a number of other peripheral EU nations are at risk for debt downgrades. Uncertainty about sovereign debt risk in the EU will generate concern about the stability of European Monetary Union and the credibility of the EUR making the EUR less attractive as an alternative reserve currency to the USD. The UK AAA debt rating is at risk if the UK government does not take credible action to reduce its debt. This is not to say that the rising US deficit is not a problem for the US but there are significant fiscal problems in other countries as well.

5) Gradual Yuan appreciation

Most of the adjustment for global rebalancing is needed with Asian countries, in particular China. Many analysts believe that significant revaluation of the Chinese Yuan would help reduce global trade balances. China remains resistant to calls for rapid revaluation of the Yuan. Because the Yuan rate is pegged global rebalancing creates upward appreciation pressures on free-floating currencies in particular the EUR. China's PM Wen recently said that China would not succumb to outside pressures too allow the Yuan to appreciate .According to the Financial Times Wen's rhetoric has become much more defiant. Wen left the door open for gradual appreciation of the Yuan but this may not be enough to limit selling of USD based on global rebalancing.

Conclusion

The USD is expected to experience short-term strength supported by Fed rate hike speculation and concern about fiscal troubles in Europe and Japan. The extent of the USD recovery will depend on the pace of the Feds withdrawal of stimulus and how the tightening cycle impacts the US recovery. We suspect that the Fed will proceed gradually. A gradual change in Fed rate policy will likely encourage fresh selling of the USD in the second half 2010 sparked by worries over the risk of a double dip recession. Economist Paul Krugman says that there is a "reasonably high chance" the US economy will contract in the second half of 2010.We agree. The risk to this outlook is the Fed dampens expectations that rates will rise in 2010.

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Michael J. Malpede is Chief Market Analyst with Easy-Forex® and has previously been featured on Bloomberg TV, Bloomberg radio, Reuters, MarketWatch, Wall Street Journal, Chicago Tribune, Chicago Sun Times, Toronto Star and Nikkei press. In analyzing the markets, he draws from 29 years of Foreign Exchange Research as a Foreign Exchange Analyst.

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